The deficit that Gillard had to have

Yes, you can argue, as
Joe Hockey
does, that the budget should have been in a surplus long before now. But, given the situation in which the government now finds itself, the Prime Minister had no option but to drop her plan to push the budget into surplus this financial year.

Federal and state fiscal consolidation already is slowing the economy and 2013 is forecast to be a year of sub-trend growth.

A further tightening of fiscal policy now would have added to the already rising rate of unemployment, purely to meet the political goal of a budget surplus before the election.

The government has run out of accounting tricks and timing changes capable of improving the budget bottom line without making a significant impact on economic activity.

Both the International Monetary Fund and the Organisation for Economic Co-operation and Development have urged the government to let the budget’s automatic stabilisers – the cyclical variations in revenue and spending that naturally pull the budget between surplus and deficit – cushion the economy from the slowdown.

But what happens to the budget now? The forces that have kept the budget in deficit in 2012-13 – primarily the high dollar and the declining terms of trade – are unlikely to let it float naturally into surplus in 2013-14. Yet that doesn’t matter very much if the government has a strong medium-term fiscal plan to get the budget back into underlying structural surplus.

That’s quite a challenge, because what is required is more than just a statement that the government will “re-order its budget priorities" to accommodate new major spending programs such as the national disability insurance scheme and school education reform. That is little more than a statement of intent.

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Both the government and the opposition should be able to nominate before next year’s election the major spending cuts or tax increases they intend to implement to restore the structural surplus.

Australia is not a heavily indebted European economy that needs to tighten fiscal policy in a weak economy to reassure financial markets and investors. But it does need a strong medium-term fiscal strategy to keep the budget in surplus over the economic cycle. And it needs the public to have a clearer understanding than so far has been conveyed by the major political parties of why the medium-term fiscal strategy is necessary.

Under the Howard government the priority was reducing debt and, in the economic circumstances of the time, an almost uninterrupted series of budget surpluses was justified. But
John Howard
’s medium-term fiscal strategy was designed for a wider set of economic conditions. The requirement was a fiscal surplus on average over the cycle, so that the budget would be in surplus in the good years and in deficit in the bad ones. The accumulation by the government of financial assets in the surplus years would offset the accumulation of debt in the recessions.

That ability of the budget to move between surplus and deficit while stabilising public debt over the economic cycle has become more important. The Australian economy is making itself more dependent on commodity prices and, therefore, more volatile. However, the OECD warns, the exchange rate may be less likely to cushion the economy from that volatility. If so, the budget’s automatic stabilisers will have to play a bigger role.

At the same time, the global financial crisis has shown that governments must maintain the fiscal room to take strong action in emergencies.

Old-fashioned discretionary fiscal policy is back because, as the Treasury’s David Gruen has explained, low inflation means low nominal interest rates, and that means some economic shocks are now too big for monetary policy and the automatic stabilisers to cope with on their own.